Yachting in Paradise, Inc., was founded late in 20X0 by retired Admiral Andy Willits to provide executive retreats aboard a luxury yacht with ports of call scattered around the South Pacific. Yachting in Paradise is a U.S. firm and follows U.S. GAAP. On January 2, 20X1, the company purchased the Sarah Mitcheltree, an Azimut 116 super yacht, for $15 million. Yachting in Paradise expects the Sarah Mitcheltree to have a life of 15 years and a $3 million residual value; the company uses straight-line depreciation. Charters, which can be arranged for periods lasting up to a month, are expected to generate annual net cash flows of $2.7 million. Business met expectations for the first few years, but by early 20X7 the company faced a significant reduction in its future cash flows. The worldwide recession was depressing charters as client companies slashed discretionary spending, but what was really impacting Yachting in Paradise’s prospects was a new—and rapidly gaining attention—phenomenon: Sick Yacht Syndrome. Norwalk virus, bilge odors, flesh eating bacteria, mold, yeast, holding tank odors, VOCs, stale air, and diesel bacteria are all indoor air problems on a yacht. While Yachting in Paradise has yet to experience any of these symptoms on its yacht, a rash of highly publicized incidents on a larger competitor’s fleet was having a ripple effect. Using probability-weighted cash flow forecasts, Yachting in Paradise now estimates that its annual net cash flows will be a disappointing $1.05 million for the next nine years and have $0 salvage value. Knowing that times were tough in the charter yacht business, a yacht broker that specializes in purchasing used luxury yachts recently offered the company $6 million for the Sarah Mitcheltree. Willits takes some comfort in knowing that at least the present value of the revised cash flows is $6.6 million, so the company will be better off by “sailing on.”

Required:

1. What circumstances should prompt Yachting in Paradise, Inc., to perform an asset impairment test?

2. Is the Sarah Mitcheltree impaired? Why or why not? If the asset is impaired, how much loss should be recognized?

3. Prepare any journal entry necessary based on your answer in requirement 2.

4. If by early 20X9 an economic recovery and a widely publicized cure for Sick Yacht Syndrome restore demand for executive yachting retreats, will this impact any entry made in requirement 3? Assume the recoverable amount at this time equals $8 million and that the original residual value remains unchanged.

5. Would your answer to requirement 4 be different if the recoverable amount equaled $10 million?